To be a ‘good bank’, a bank must be efficient, innovative and trustworthy.
Given its central role at the heart of the economy and financial system and the risks associated with fulfilling its role, banks have to operate within an environment subject to laws, regulations and directives. Outcomes can often be subject to the constraints of such supervision, but not entirely. In fact, apart from the regulation that sets out the rules of the game, supervision should naturally complement activities, offering degrees of regulatory freedom within the constraints of stated standards in order to help banks achieve the best outcome possible from a business and economic perspective.
Supervision includes all actions performed in order to monitor the operation of banks and the banking system. It reports on normal or abnormal operations, and ensures compliance within the constraints imposed by stated standards. So if supervision is a factor in strengthening the confidence of economic agents towards banks, can we say that all types of supervision provide such confidence?
BENEFITS OF SUPERVISION
Supervision exerted on banks can identify system malfunctions. It reports to and alerts economic agents, governments and supranational organisations on any deviations from targets and references set. Such controls are used to inform on the efficiency of rules and to provide crucial information on the relationship of trust between the bank and its operating environment. In this sense, supervision as a body measuring compliance with the regulations is a contributing factor to strengthening confidence in the banking sector. The results of the checks carried out by supervisors are the tools enabling the measurement of compliance and respectability of a bank.
However, this argument needs to be qualified. Indeed, within this framework, the depth and relevance of monitoring is neither unique nor uniform, but complex in both its nature and its philosophy. As a result, the quality of the information provided by the supervisor is variable and needs to be placed in context of the field of practice. Taking this argument a stage further, we can say that the quality of information provided by a supervisor to ensure compliance with the rules is not exactly comparable to that provided by a supervisor to ensure compliance with the principles.
RULES VS PRINCIPLESThe quality of information provided by a supervisor to ensure compliance with the rules is not exactly comparable to that provided by a supervisor to ensure compliance with the principles.
In the first case, the supervisor’s role is clearly defined. Reporting duties are clear, but the scope of rules-bases supervision is limited. In terms of compliance there is no grey area, no in-between, no possibility to interpret or arbitrate. The rule is simple, it applies uniformly to all. This approach considers that a rule is valid for the entire system and all banks, regardless of the environment, internal organization or business model. It’s the so called “one fits all approach”. So the way rules are applied to investment banks and retail banks are broadly identical.
The supervisor reports on compliance or violation of the rules, the information are factual. Equal treatment and consistency of approach by the rules help ensure comparability without risk of distortion. Either the rule is respected, or it is not. The approach is Manichean, black and white. It is easy to implement, easy to understand and, in addition, because of its relative simplicity, it is usually inexpensive to deploy.
This type of control and supervision includes the requirement for banks to operate, for example, within a minimum reserve ratio in line with solvency rules, although such controls are not designed to monitor the ratio, but report only when it is breached. As we have all witnessed over the recent years, following a rule on, say,ratio does not necessarily allow us to conclude that a bank or the banking system is sound, or doesn’t negate the potential risk of failure.
The question that arises in a rules-based approach, is whether what is defined is relevant and effective with regard to the risks, level of financial innovation and practicalities of banking. In this approach, the supervisor is simply the subordinate. The regulator is the central element formulating and setting controls and delegating their implementation. The supervisor does not have any allowance to assess the situation, or adapt controls and alerts. This can lead to a certain rigidity, or a lack of adequate controls in times of rapid change in the operating environment or period of intensive technical innovation not accounted for in the regulatory framework.
A MORE INDIVIDUALISED APPROACH TO SUPERVISION
In the second scenario, the supervisor’s job is different as it is more involved and controls are less rigid. Monitoring principles-based compliance allows the supervisor to, interpret and make a judgement.
The approach of principles-based supervision implicitly assumes that each component of the system; each bank has a specific profile and, therefore, it is necessary to adapt monitoring and controls individually. This more individualised approach allows for a more practical implementation of the principles suited to different business models, risk profiles and various organisations. The supervisor has to take account of all these dimensions, and confront those supervised before coming to any conclusion on compliance. Controls can be adjusted to changes in the operating environment and the strategy deployed by each bank, while at the same time taking into account any technical innovation and risks associated with the emergence of new financial products.
In taking this approach, the comparison between institutions becomes more complex. This is especially true when there is more than one regulatory body involved which can lead to a lack of uniform interpretation and different supervisory frameworks. Also national supervision that lacks real integration for global entities demonstrates that the application of common regulations could lead to very different interpretations. The International Financial Reporting Standards (IFRS) is an illustration of the difficulties involved in comparing institutions on principles-based supervision, despite one of the first objectives of IFRS being to strengthen such comparisons. The treatment of impairments during the restructuring of Greek debt in 2011 highlighted how, based on principles, the same event could lead to different treatments while remaining compliant with the regulations.
The latitude of interpretation left to the supervisor is such that there is participation in regulation through the level of interaction system are made through intervention, actions and consequences, but also through the lack of separation of tasks between inspector and regulator. Indeed, because the supervisor inspects, educates and judges. in some respects the supervisor replaces the regulator.
These multiple elements require banks to have confidence that the supervisor is able resolve any problems and has a sufficient number and quality of staff to fully function in its role. This includes having expert teams who are not only able to interpret the principles, understand organisations and their different risks and business models, but also to exercise separately the tasks involved in control, validation, and judgment. Implementing such a strategy has a substantially higher cost to that of a rule-based approach.
Taking into account economic and social conditions, banks evolve in line with constraints set by the regulator and controlled by the supervisor. In essence, banks are not alone in creating an image of respectability, operating efficiently or freedom to innovate. A good bank needs good supervision to achieve these objectives. Yet, while the different approaches and philosophies of the supervisory systems currently deployed have their qualities, they also have defects which can deter rather than facilitate a bank’s objectives.
Principles-based supervision is expensive, requires analysis, is mixed in its application and does not facilitate comparability. But it can adapt to a changing environment or period of rapid financial innovation .This means principles-based supervision, particularly European can offer a more complete approach than rules-based supervision, which although fast to implement, consistent and facilitates comparability, has a certain rigidity and risks being obsolete if the regulation is not revised on a regular basis.
Future developments in banking mean a mix of principles and rules-based regulation and supervision, with minimum frameworks and a single supervisory body will be crucial for banks. And Europeans who are advancing towards increased integration seem more aware of the importance of this.